I'm a husband, father, author, cyclist, sailor, travel addict, and former Silicon Valley software engineer. I've written 3 books and actively review books on this blog.
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Wednesday, August 06, 2008

I was recently on an email thread where people were talking about housing as an investment. In response to an assertion that housing has historically returned less than the S&P 500, someone asked, "Are you counting the rent that you aren't paying?" My answer:

Yes.

House prices nationwide (sorry for the US-bias, but I don't have data for international markets) have very poor inflation-adjusted returns. Shiller (of the Case-Shiller house price indices) showed that house prices appreciated by 0.4% a year after inflation, from 1870-2004.

If you buy a house, you don't pay rent. But instead, you either pay for your mortgage interest, or you lose out on the return you could have had if your house were invested in stocks. Assume that you're paying your mortgage interest. At a 6% mortgage rate, you're paying .5% of your house price a month in mortgage. People don't call it rent, but that's exactly what you're doing -- renting money to "own" the house so that you can live in it. Even at the highest tax brackets and the mortgage deduction (call it ~40%) that's still .3% of the house price a month in mortgage costs. Historically, house prices and rents have moved together (and there's good reason for them to -- if house prices rise relative to rents, people will choose to rent, driving up rents and driving down house prices). That ratio (house price to yearly rent) has been about 21 or so. When that ratio goes higher, houses are expensive and renting is cheap. When it goes lower, renting is expensive.

So if your house is $X, and you're paying .3% (after taxes) a month in mortgage "rent", that's .036X a year in mortgage "rent". The inverse of that, 27.8, is the price to rent ratio. But remember that that simple calculation ignores costs of ownership -- property taxes (add 1% of X yearly), maintenance (another 1% ish), and so forth. You get to the point where the cost of home ownership is very similar to the cost of renting. Add .6% for property taxes (after the tax deduction), 1% for maintenance (no tax deduction there!), and you're paying .052X a year to own the house. That's a price to rent of about 19.2. With an historical ratio of about 21, you could have rented an equivalent apartment (or house) for less money. Suddenly renting looks like the better deal. The point here is that owning a home, by way of a mortgage, is expensive.

Choose instead to pay cash for the house so there is no mortgage. (We can all dream.) Now, instead you're losing out on the possibility of investing that money. If your house is $X, you lose out on the risk-free rate times X. Right now, that's the t-bill rate of about 1.52%, or almost 1% after taxes (no state taxes on treasuries). (I note here for completeness that this is an historically low rate.) You still have to pay property taxes and maintenance (1.6% after taxes). Now, you're paying .026X a year to own the house, for a price to rent of about 38. Wow, ownership looks great!

Of course, you could have taken that money and invested it in something slightly riskier, like a diversified stock+bond portfolio, making something like 7% a year. (And that's certainly a more liquid asset than a house!) There will be up and down years, but say long-term you can make 7% a year. You have to pay taxes, so let's generously (from a "woohoo housing" perspective) assume it's all taxed as income at your marginal tax rate. That's 4.2% after taxes. Add in property taxes and maintenance, that's 5.8% after taxes. Ouch. Price to rent is just 17.2.

We haven't even considered the transaction costs of home ownership. For starters, you pay 6% to a realtor just to move, which you have to remember to subtract from your returns. There's the cost of applying for the mortgage, ...

In short, home ownership isn't a good deal. There are certainly regions of the US where it *has* been a good deal in the past. However, the main reason people make money on home ownership is because of their leveraged investment by way of a mortgage. If you want leverage, start stocking up on S&P 500 futures or something.